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The Scariest Number for Investors in a "Nowhere to Hide" Market

Coming to grips with the reality of today's market.

Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

On the back of their worst monthly performance since May 2012, U.S. stocks started the month of September on the right foot, chalking up a small gain. The S&P 500(SNPINDEX:^GSPC) rose 0.4%, while the narrower, price-weighted Dow Jones Industrial Average(DJINDICES:^DJI), held back by its weightings in today's dealmakers, Verizon and Microsoft, could only manage a 0.2% advance.

Those small gains were enough for a 2.3% drop in the CBOE Volatility Index(VOLATILITYINDICES:^VIX). The VIX, Wall Street's "fear index," is calculated from S&P 500 option prices and reflects investor expectations for stock market volatility over the coming 30 days. Still, that could easily reverse with a U.S. strike on Syria -- an action for which President Obama has now gathered support from key figures in Congress, according to Reuters.

Your return expectations are too highAs the italicized text at the top of this article highlights, we at The Motley Fool are long-term investors. If your primary concern is what will happen in the markets tomorrow, this month, or even over the next six months, I suggest you click on to the next article immediately. The following discussion concerns the return you can expect to earn over the next five to 10 years -- which is essentially the minimum time horizon an investor -- not a trader, but a genuine investor -- should have in mind when he or she buys stocks.

Respected financial weekly Barron's interviewed [sign-up may be required] hedge and mutual fund manager Cliff Asness for its weekend edition. Asness, who earned his Ph.D. in finance at the University of Chicago, runs AQR Capital Management (AQR stands for Applied Quantitative Research -- Asness is a "quant.") Asness is an outspoken, emotional character who is sometimes controversial, but when it comes to investing, he is absolutely rock solid, with a firm grounding in theory and data.

Before I share some of Asness's thoughts, ask yourself: What do you expect to earn, on an annualized basis and after inflation, on your entire portfolio (equities, bonds, cash, etc) over the next 10 years? 5%? 10%? 15%. Here's what Asness thinks is reasonable:

This is U.S. stocks and bonds, but it's not that different if you do it globally. Historically, we think about real returns, and that 60-40 portfolio has delivered about 5% per annum over inflation over the long term. However, passive investors now would be better off to assume about a 2.5% real return, which is still positive and still going to beat inflation.

Only 2.5%! Why so low? It all comes down to valuation, or price versus fundamentals:

We don't look at much else besides price. Business cycles, short-term earnings growth, who's beating their number, what the Fed does next week—that all does matter a lot over the short term. But over the long term, while there is no perfect predictor, the only factor that has decent predictive power is, "What price am I paying against fundamentals?"

The problem for investors, is that, right now, that 60-40 stock/ bond portfolio looks very expensive indeed:

The 60-40 portfolio has been cheaper than it is now 98% of the time. Now, we've seen more-expensive bond markets, and we've seen more-expensive equity markets. For instance, right now it's not close to the peak of the tech bubble in 1999-2000. However, the stock and bond markets are usually not expensive, with a low expected return, at the same time... very often when one asset class is very expensive, the other one isn't. Right now, they are different degrees of very expensive, and the combination is even more extreme than either one. So that really is sad news for passive investors. Actually, it's sad news for all investors. It means there is no place to hide, even if you are a believer in long-term tactical asset allocation.

In other words, separately, stocks and bonds have been more expensive than they are today, but it's very rare that they are as expensive together as they are now. Is Asness correct that there is no place to hide? One could raise one's allocation to cash and wait for stocks or bonds to become more attractive valuation-wise, but that carries risks of its own. Raising one's allocation to stocks to raise the expected return of the portfolio is a non-starter -- you're not being properly compensated to do this.

One of the best solutions I can think of isn't to own more stocks but better-chosen ones, i.e., when stocks as an asset class are expensive, stock picking can really show its worth. But while identifying that strategy is easy enough, implementing it is extremely challenging. It takes a lot of skill and experience. For individual investors, the easiest path is probably to allocate money to mutual funds run by successful value investors.